There are many things to be said about what we should do in the current situation, but let met focus on main themes. First, our banking and financial markets need to be fixed. Banking firms must play their appropriate roles in our economy. If they function well then the use they serve will be sustainable and have expanded wealth positions. If not, then it’s the financial system, not those units, that fail. That means that we have let the predators take prey rather than constructing a functional system. That also means that we cannot afford to think of our financial sector as a source of national competitive advantage, as we have been thinking about it up to now.
Secondly, the borrower-lender relationship which is at the core of banking has been compromised and must be restored. There’s a mismatch between the units engaged in risk-taking and those engaged in risk-bearing. Perry just offered one kind of solution to that, which is to try to find an anchor for the risk-bearing side of it, and I think we need to have a debate about that. The zone of businesses and households encompassed by normal bank lending has shrunk as banks moved towards standardized metrics. These standardized metrics have sometimes been used wisely, but more often they have been used to fine-tune either financial exclusion or, more lately, financial exploitation. This has to stop. Banks must lend to borrowers and bear the risks of their lending. They must make loans they do not expect to fail. We cannot insure against that. We have similar discussions about wildfires in California. Some of my policy friends, geologists and others, want to insure against wildfire risk with bearer bonds. My point would be, if houses burn, you must put out the fire.
Something like that is going on right now in the banking sector. Banks must, in my view, be clearly distinguished from financial firms that are involved in risk exchange and in zero-sum speculative bets. There should be a firewall between these markets, the markets that trade risk in real time and markets that originate credit and capital and nurture it through time.
In my view, at the hub of this is this question of what a bank holding company really is. And I suggest going back to this very simple definition: A bank holding company is an entity whose principal rea- son for being is commercial banking. It may engage in activities closely related to banking, as was said in the 1956 Bank Holding Company Act, but not much more than that. You should not be able to become the bank holding company because it serves your convenience, and you must not be able to maintain your strategies, as Morgan Stanley promised the other day, while maintaining that cover of privilege. It’s just wrong. It’s predatory, in James Galbraith words.
The scope and purpose of government guarantees of banking must be reconsidered. The expansion of implicit government underwriting has to be reconsidered as well. I think 100-percent guarantees must be carefully nurtured.
This brings us to the problem of regulation and the control of abuse of market relations by banks and the players in financial markets. There are two areas to control: speculation and financial exploitation and/or exclusion. As for the speculation, I think we have to be very careful about allowing our mega-banks to directly or indirectly position themselves to make money from either side or both sides of zero-sum trade-offs for borrowers. We have to make sure that our regulatory authorities have adequate scope of coverage, so that any intermediary that offloads risks must do so in such a way that those risks can be monitored transparently and in a timely manner. AIG is a case in point. We must insure that there’s principle agent responsi-bility in funds and sub-funds. And I think the idea of passive financial intermediaries has got to be retired.
The second aspect of regulation is about fighting against financial exploitation and exclusion. There must be meaningful regulatory inspections and expanded public reporting on the volumes and pri- ces in all lines of financial business, both its formal and informal sectors. This regulatoy power must include penalties for the denial of credit to areas, individuals, and businesses on the basis of race and gender, as well as penalties for selling overly risky credit contracts to them. That’s basically the Community Reinvestment Act. And that’s a key part. One must keep in mind that the African-American com- munity was one of the key components in bringing Barack Obama to power and that it was the very first victim of the sub-prime crisis. The growth of sub-prime loans in the inner cities of our country was 900 percent between 1993 and 1999; while forms of regular mortgages went down. That is a political fact that has to be kept in mind.
Large banks, if they are too big to fail, must meet a higher community reinvestment standard, and we’ve got, I think, to remove the Federal Reserve from the business of bank regulatory oversight since it interprets safety far too narrowly.
« There must be meaningful regulatory inspections and expanded public reporting in all lines of financial business."
Let me move on to housing and mortgages. I think in the short term we’ve got to keep people in their houses. The powerful finance system that we now have for mortgages is designed to flush foreclosures through. But allowing people to sell their homes for non-viable mortgages stabilizes nothing – what we obviously need is a balanced mix of fairness and incentive incompatibility that has to be found. We should start by taking an inventory of houses that are delinquent and divide them into owner-occupied and others. It’s not the right time to try to find the market value in markets like California or Detroit. Let’s find out the basics: how much are these people actually paying? Can they make it? And what relief on a sliding scale can we offer them? The government can take an interest in your home with you and keep it until you sell it, at which point it cashes in, as do you. That’s something like the Homeowner’s Loan Corporation that Paul has suggested reviving.
In addition, we might need incentives for housing construction. In California we have about 500,000 people a year moving in, and we’re building about 225,000 units of housing every year. Thus, we’re housing less than half of our increment. That’s a big source of the housing bubble. According to my colleagues from state government, restoring the federal rental housing credit would be very useful. The 1986 reforms really took the teeth out of it and resulted in a down- ward bump, especially in multi-family housing, which is where we really need some help right now. In the longer term, we should use land-use taxes in order to remove funds from areas where there has been inadequate attention to the need to create lower-income housing or mixed-use housing and to use proceeds from such peoples’ homes to build affordable housing somewhere.
My third point is about the stimulus to state and local governments. I had a chance to reread Cary Brown’s wonderful analysis from 1957 about the Great Depression and fiscal policy. The point he made is that it didn’t really kick in for a long time, and the reason for this were the tax increases, especially at the state and local level, that almost offset the impact of the federal stimulus. That is going to happen today in states like California and others. In California, we have about a $20 billion deficit. If you take into account state, county, cities, and municipalities, some part of it’s self-inflicted, but not all of it; and basically we’re now facing the Republican Caucus in our state, which is fierce, pointing out that raising taxes is the wrong thing to do in a recession. Of course they’re right; and the advocates on the other side, like my friends at the California Budget Project who talk about things like maintaining unemployment insurance and stabilizing Medicaid, think that this is no time to cut poor people’s expenditures either. They’re both right, and that’s why we need some form of revenue sha- ring. James Galbraith has been calling for it for a long time, and we have to hope that it happens.